FDIC Law, Regulations, Related Acts

5000 - Statements of Policy

Policy Statement on Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Institutions

July 2, 2001.

Boards of directors of banks and savings institutions are
responsible for ensuring that their institutions have controls in place
to consistently determine the allowance for loan and lease losses
(ALLL) in accordance with the institutions' stated policies and
procedures, generally accepted accounting principles (GAAP), and ALLL
supervisory guidance.1
To fulfill this responsibility, boards of directors instruct management
to develop and maintain an appropriate, systematic, and consistently
applied process to determine the amounts of the ALLL and provisions for
loan losses. Management should create and implement suitable policies
and procedures to communicate the ALLL process internally to all
applicable personnel. Regardless of who develops and implements these
policies, procedures, and underlying controls, the board of directors
should assure themselves that the policies specifically address the
institution's unique goals, systems, risk profile, personnel, and
other resources before approving them. Additionally, by creating an
environment that encourages personnel to follow these policies and
procedures, management improves procedural discipline and compliance.

The determination of the amounts of the ALLL and provisions for loan
and lease losses should be based on management's current judgments
about the credit quality of the loan portfolio, and should consider all
known relevant internal and external factors that affect loan
collectibility as of the reporting date. The amounts reported each
period for the provision for loan and lease losses and the ALLL should
be reviewed and approved by the board of directors. To ensure the
methodology remains appropriate for the institution, the board of
directors should have the methodology periodically validated and, if
appropriate, revised. Further, the audit
committee2
should oversee and monitor the internal controls over the ALLL
determination process.3

The banking agencies4
have longstanding examination policies that call for examiners to
review an institution's lending and loan review functions and
recommend improvements, if needed. Additionally, in 1995 and 1996, the
banking agencies adopted interagency guidelines establishing standards
for safety and soundness, pursuant to Section 39 of the Federal Deposit
Insurance Act (FDI Act).5
The interagency asset quality guidelines and the guidance in this paper
assist an institution in estimating and establishing a sufficient ALLL
supported by adequate documentation, as required under the FDI Act.
Additionally, the guidelines require operational and managerial
standards that are appropriate for an institution's size and the
nature and scope of its activities.

For financial reporting purposes, including regulatory reporting,
the provision for loan and lease losses and the ALLL must be determined
in accordance with GAAP. GAAP requires that allowances be well
documented, with clear explanations of the supporting
analyses and
rationale.6
This Policy Statement describes but does not increase the documentation
requirements already existing within GAAP. Failure to maintain,
analyze, or support an adequate ALLL in accordance with GAAP and
supervisory guidance is generally an unsafe and unsound banking
practice.7

This guidance applies equally to all institutions, regardless of the
size. However, institutions with less complex lending activities and
products may find it more efficient to combine a number of procedures
(e.g., information gathering, documentation, and internal
approval processes) while continuing to ensure the institution has a
consistent and appropriate methodology. Thus, much of the supporting
documentation required for an institution with more complex products or
portfolios may be combined into fewer supporting documents in an
institution with less complex products or portfolios. For example,
simplified documentation can include spreadsheets, check lists, and
other summary documents that many institutions currently use.
Illustrations A and C provide specific examples of how less complex
institutions may determine and document portions of their loan loss
allowance.

Documentation Standards

Appropriate written supporting documentation for the loan loss
provision and allowance facilitates review of the ALLL process and
reported amounts, builds discipline and consistency into the ALLL
determination process, and improves the process for estimating loan and
lease losses by helping to ensure that all relevant factors are
appropriately considered in the ALLL analysis. An institution should
document the relationship between the findings of its detailed review
of the loan portfolio and the amount of the ALLL and the provision for
loan and lease losses reported in each
period.8

At a minimum, institutions should maintain written supporting
documentation for the following decisions, strategies, and processes:

(1) Policies and procedures:

(a) Over the systems and controls that maintain an appropriate
ALLL and

(b) Over the ALLL methodology,

(2) Loan grading system or process,

(3) Summary or consolidation of the ALLL balance,

(4) Validation of the ALLL methodology, and

(5) Periodic adjustments to the ALLL process.

The following sections of this Policy Statement provide guidance on
significant aspects of ALLL methodologies and documentation practices.
Specifically, the paper provides documentation guidance on:

Financial institutions utilize a wide range of policies, procedures,
and control systems in their ALLL process. Sound policies should be
appropriately tailored to the size and complexity of the institution
and its loan portfolio.

In order for an institution's ALLL methodology to be effective, the
institution's written policies and procedures for the systems and
controls that maintain an appropriate ALLL should address but not be
limited to:

(1) The roles and responsibilities of the institution's
departments and personnel (including the lending function, credit
review, financial reporting, internal audit, senior management, audit
committee, board of directors, and others, as applicable) who
determine, or review, as applicable, the ALLL to be reported in the
financial statements;

(2) The institution's accounting policies for loans and loan
losses, including the policies for charge-offs and recoveries and for
estimating the fair value of collateral, where applicable;

(3) The description of the institution's systematic methodology,
which should be consistent with the institution's accounting policies
for determining its ALLL;9
and

(4) The system of internal controls used to ensure that the ALLL
process is maintained in accordance with GAAP and supervisory guidance.

An internal control system for the ALLL estimation process should:

(1) Include measures to provide assurance regarding the
reliability and integrity of information and compliance with laws,
regulations, and internal policies and procedures;

(2) Reasonably assure that the institution's financial
statements (including regulatory reports) are prepared in accordance
with GAAP and ALLL supervisory
guidance;10
and

(3) Include a well-defined loan review process containing:

(a) An effective loan grading system that is consistently
applied, identifies differing risk characteristics and loan quality
problems accurately and in a timely manner, and prompts appropriate
administrative actions;

(b) Sufficient internal controls to ensure that all relevant loan
review information is appropriately considered in estimating losses.
This includes maintaining appropriate reports, details of reviews
performed, and identification of personnel involved; and

(c) Clear formal communication and coordination between an
institution's credit administration function, financial reporting
group, management, board of directors, and others who are involved in
the ALLL determination or review process, as applicable (e.g., written
policies and procedures, management reports, audit programs, and
committee minutes).

Methodology

An ALLL methodology is a system that an institution designs and
implements to reasonably estimate loan and lease losses as of the
financial statement date. It is critical that ALLL methodologies
incorporate management's current judgments about the credit quality of
the loan portfolio through a disciplined and consistently applied
process.

An institution's ALLL methodology is influenced by
institution-specific factors, such as an institution's size,
organizational structure, business environment and strategy, management
style, loan portfolio characteristics, loan administration procedures,
and management information systems. However, there are certain common
elements an institution should incorporate in its ALLL methodology. A
summary of common elements is provided in Appendix
B.11

Documentation of ALLL Methodology in Written Policies and Procedures

An institution's written policies and procedures should describe
the primary elements of the institution's ALLL methodology, including
portfolio segmentation and impairment measurement. In order for an
institution's ALLL methodology to be effective, the institution's
written policies and procedures should describe the methodology:

(1) For segmenting the portfolio:

(a) How the segmentation process is performed (i.e., by loan
type, industry, risk rates, etc.),

(b) When a loan grading system is used to segment the portfolio:

(i) The definitions of each loan grade,

(ii) A reconciliation of the internal loan grades to supervisory
loan grades, and

(iii) The delineation of responsibilities for the loan grading
system.

(2) For determining and measuring impairment under FAS 114:

(a) The methods used to identify loans to be analyzed
individually;

(b) For individually reviewed loans that are impaired, how the
amount of any impairment is determined and measured, including:

(i) Procedures describing the impairment measurement techniques
available and

(ii) Steps performed to determine which technique is most
appropriate in a given situation.

(c) The methods used to determine whether and how loans
individually evaluated under FAS 114, but not considered to be
individually impaired, should be grouped with other loans that share
common characteristics for impairment evaluation under FAS 5.

(3) For determining and measuring impairment under FAS 5:

(a) How loans with similar characteristics are grouped to be
evaluated for loan collectibility (such as loan type, past-due status,
and risk);

(b) How loss rates are determined (e.g., historical loss rates
adjusted for environmental factors or migration analysis) and what
factors are considered when establishing appropriate time frames over
which to evaluate loss experience; and

(c) Descriptions of qualitative factors (e.g., industry,
geographical, economic, and political factors) that may affect loss
rates or other loss measurements.

The supporting documents for the ALLL may be integrated in an
institution's credit files, loan review reports or worksheets, board
of directors' and committee meeting minutes, computer reports, or
other appropriate documents and files.

ALLL Under FAS 114

An institution's ALLL methodology related to FAS 114 loans begins
with the use of its normal loan review procedures to identify whether a
loan is impaired as defined by the accounting standard. Institutions
should document:

(1) The method and process for identifying loans to be evaluated
under FAS 114 and

(2) The analysis that resulted in an impairment decision for each
loan and the determination of the impairment measurement method to be
used (i.e., present value of expected future cash flows, fair value of
collateral less costs to sell, or the loan's observable market price).

Once an institution has determined which of the three available
measurement methods to use for an impaired loan under FAS 114, it
should maintain supporting documentation as follows:

(1) When using the present value of expected future cash flows
method:

(a) The amount and timing of cash flows,

(b) The effective interest rate used to discount the cash flows,
and

(c) The basis for the determination of cash flows, including
consideration of current environmental factors and other information
reflecting past events and current conditions.

(2) When using the fair value of collateral method:

(a) How fair value was determined, including the use of
appraisals, valuation assumptions, and calculations,

(b) The supporting rationale for adjustments to appraised values,
if any,

(c) The determination of costs to sell, if applicable, and

(d) Appraisal quality, and the expertise and independence of the
appraiser.

(3) When using the observable market price of a loan method:

(a) The amount, source, and date of the observable market price.

Illustration A describes a practice used by a small financial
institution to document its FAS 114 measurement of impairment using a
comprehensive worksheet.12
Q&A #1 and #2 in Appendix A provide examples of applying and
documenting impairment measurement methods under FAS 114.

Begin Text Box--Illustration A (Documenting an ALLL Under
FAS 114, Comprehensive worksheet for the impairment measurement
process): A small institution utilizes a comprehensive worksheet for
each loan being reviewed individually under FAS 114. Each worksheet
includes a description of why the loan was selected for individual
review, the impairment measurement technique used, the measurement
calculation, a comparison to the current loan balance, and the amount
of the ALLL for that loan. The rationale for the impairment measurement
technique used (e.g., present value of expected future cash flows,
observable market price of the loan, fair value of the collateral) is
also described on the worksheet. End Text Box

Some loans that are evaluated individually for impairment under FAS
114 may be fully collateralized and therefore require no ALLL. Q&A #3
in Appendix A presents an example of an institution whose loan
portfolio includes fully collateralized loans and describes the
documentation maintained by that institution to support its conclusion
that no ALLL was needed for those loans.

ALLL Under FAS 5

Segmenting the Portfolio

For loans evaluated on a group basis under FAS 5, management should
segment the loan portfolio by identifying risk characteristics that are
common to groups of loans. Institutions typically decide how to segment
their loan portfolios based on many factors, which vary with their
business strategies as well as their information system capabilities.
Smaller institutions that are involved in less complex activities often
segment the portfolio into broad loan categories. This method of
segmenting the portfolio is likely to be appropriate in only small
institutions offering a narrow range of loan products. Larger
institutions typically offer a more diverse and complex mix of loan
products. Such institutions may start by segmenting the portfolio into
major loan types but typically have more detailed information available
that allows them to further segregate the portfolio into product line
segments based on the risk characteristics of each portfolio segment.
Regardless of the segmentation method used, an institution should
maintain documentation to support its conclusion that the loans in each
segment have similar attributes or characteristics.

As economic and other business conditions change, institutions often
modify their business strategies, which may result in adjustments to
the way in which they segment their loan portfolio for purposes of
estimating loan losses. Illustration B presents an example
in
which an institution refined its segmentation
method to more effectively consider risk factors and maintains
documentation to support this change.

Begin Text Box--Illustration B (Documenting Segmenting
Practices, Documenting a refinement in a segmentation method): An
institution with a significant portfolio of consumer loans performed a
review of its ALLL methodology. The institution had determined its ALLL
based upon historical loss rates in the overall consumer portfolio. The
ALLL methodology was validated by comparing actual loss rates
(charge-offs) for the past two years to the estimated loss rates.
During this process, the institution decided to evaluate loss rates on
an individual product basis (e.g., auto loans, unsecured loans or home
equity loans). This analysis disclosed significant differences in the
loss rates on different products. With this additional information, the
methodology was amended in the current period to segment the portfolio
by product, resulting in a better estimation of the loan losses
associated with the portfolio. To support this change in segmentation
practice, the credit review committee records contain the analysis that
was used as a basis for the change and the written report describing
the need for the change End Text Box.

Institutions use a variety of documents to support the segmentation
of their portfolios. Some of these documents include:

(1) Loan trial balances by categories and types of loans,

(2) Management reports about the mix of loans in the portfolio,

(3) Delinquency and nonaccrual reports, and

(4) A summary presentation of the results of an internal or
external loan grading review.

Reports generated to assess the profitability of a loan product line
may be useful in identifying areas in which to further segment the
portfolio,

Estimating Loss on Groups of Loans

Based on the segmentation of the loan portfolio, an institution
should estimate the FAS 5 portion of its ALLL. For those segments that
require an ALLL,13
the institution should estimate the loan and lease losses, on at least
a quarterly basis, based upon its ongoing loan review process and
analysis of loan performance. The institution should follow a
systematic and consistently applied approach to select the most
appropriate loss measurement methods and support its conclusions and
rationale with written documentation. Regardless of the methods used to
measure losses, an institution should demonstrate and document that the
loss measurement methods used to estimate the ALLL for each segment are
determined in accordance with GAAP as of the financial statement
date.14

One method of estimating loan losses for groups of loans is through
the application of loss rates to the groups' aggregate loan balances.
Such loss rates typically reflect the institution's historical loan
loss experience for each group of loans, adjusted for relevant
environmental factors (e.g., industry, geographical, economic, and
political factors) over a defined period of time. If an institution
does not have loss experience of its own, it may be appropriate to
reference the loss experience of other institutions, provided that the
institution demonstrates that the attributes of the loans in its
portfolio segment are similar to those of the loans included in the
portfolio of the institution providing the loss
experience.15
Institutions should maintain supporting documentation for the technique
used to develop their loss rates, including the period of time over
which the losses were incurred. If a range of loss is determined,
institutions should maintain documentation to support the identified
range and the rationale used for determining which estimate is the best
estimate within the range of loan losses. An example of how a small
institution performs a comprehensive historical loss analysis is
provided as the first item in Illustration C.

Before employing a loss estimation model, an institution should
evaluate and modify, as needed, the model's assumptions to ensure that
the resulting loss estimate is consistent with GAAP. In order to
demonstrate consistency with GAAP, institutions that use loss
estimation models typically document the evaluation, the conclusions
regarding the appropriateness of estimating loan losses with a model or
other loss estimation tool, and the support for adjustments to the
model or its results.

Begin Text Box--Illustration C (Documenting the Setting
of Loss Rates, First Illustration, Comprehensive loss analysis in a
small institution): A small institution determines its loss rates based
on loss rates over a three-year historical period. The analysis is
conducted by type of loan and is further segmented by originating
branch office. The analysis considers charge-offs and recoveries in
determining the loss rate. The institution also considers the loss
rates for each loan grade and compares them to historical losses on
similarly rated loans in arriving at the historical loss factor. The
institution maintains supporting documentation for its loss factor
analysis, including historical losses by type of loan, originating
branch office, and loan grade for the three-year period.

(Second Illustration, Adjustment of loss rates for changes in local
economic conditions): An institution develops a factor to adjust loss
rates for its assessment of the impact of changes in the local economy.
For example, when analyzing the loss rate on commercial real estate
loans, the assessment identifies changes in recent commercial building
occupancy rates. The institution generally finds the occupancy
statistics to be a good indicator of probable losses on these types of
loans. The institution maintains documentation that summarizes the
relationship between current occupancy rates and its loss experience.
End Text Box

In developing loss measurements, institutions should consider the
impact of current environmental factors and then document which factors
were used in the analysis and how those factors affected the loss
measurements. Factors that should be considered in developing loss
measurements include the following:16

(1) Levels of and trends in delinquencies and impaired loans;

(2) Levels of and trends in charge-offs and recoveries;

(3) Trends in volume and terms of loans;

(4) Effects of any changes in risk selection and underwriting
standards, and other changes in lending policies, procedures, and
practices;

(5) Experience, ability, and depth of lending management and
other relevant staff;

(6) National and local economic trends and conditions;

(7) Industry conditions; and

(8) Effects of changes in credit concentrations.

For any adjustment of loss measurements for environmental factors,
the institution should maintain sufficient, objective evidence to
support the amount of the adjustment and to explain why the adjustment
is necessary to reflect current information, events, circumstances, and
conditions in the loss measurements.

The second item in Illustration C provides an example of how an
institution adjusts its commercial real estate historical loss rates
for changes in local economic conditions. Q&A #4 in Appendix A provides
an example of maintaining supporting documentation for adjustments to
portfolio segment loss rates for an environmental factor related to an
economic downturn in the borrower's primary industry. Q&A #5 in
Appendix A describes one institution's process for determining and
documenting an ALLL for loans that are not individually impaired but
have characteristics indicating there are loan losses on a group basis.

Consolidating the Loss Estimates

To verify that ALLL balances are presented fairly in accordance with
GAAP and are auditable, management should prepare a document that
summarizes the amount to be reported in the financial statements for
the ALLL. The board of directors should review and approve this
summary.

Common elements in such summaries include:

(1) The estimate of the probable loss or range of loss incurred
for each category evaluated (e.g., individually evaluated impaired
loans, homogeneous pools, and other groups of loans that are
collectively evaluated for impairment);

(2) The aggregate probable loss estimated using the
institution's methodology;

(5) Depending on the level of detail that supports the ALLL
analysis, detailed subschedules of loss estimates that reconcile to the
summary schedule.

Illustration D describes how an institution documents its estimated
explanations to its summary schedule.

Begin Text Box--Illustration D (Summarizing Loss
Estimates, Descriptive comments added to the consolidated ALLL summary
schedule): To simplify the supporting documentation process and to
eliminate redundancy, an institution adds detailed supporting
information to its summary schedule. For example, this institution's
board of directors receives, within the body of the ALLL summary
schedule, a brief description of the institution's policy for
selecting loans for evaluation under FAS 114. Additionally, the
institution identifies which FAS 114 impairment measurement method was
used for each individually reviewed impaired loan. Other items on the
schedule include a brief description of the loss factors for each
segment of the loan portfolio, the basis for adjustments to loss rates,
and explanations of changes in ALLL amounts from period to period,
including cross-references to more detailed supporting documents.
End Text Box

Generally, an institutions's review and approval process for the
ALLL relies upon the data provided in these consolidated summaries.
There may be instances in which individuals or committees that review
the ALLL methodology and resulting allowance balance identify
adjustments that need to be made to the loss estimates to provide a
better estimate of loan losses. These changes may be due to information
not known at the time of the initial loss estimate (e.g., information
that surfaces after determining and adjusting, as necessary, historical
loss rates, or a recent decline in the marketability or property after
conducting a FAS 114 valuation based upon the fair value of
collateral). It is important that these adjustments are consistent with
GAAP and are reviewed and approved by appropriate personnel.
Additionally, the summary should provide each subsequent reviewer with
an understanding of the support behind these adjustments. Therefore,
management should document the nature of any adjustments and the
underlying rationale for making the changes. This documentation should
be provided to those making the final determination of the ALLL amount.
Q&A #6 in Appendix A addresses the documentation of the final amount of
the ALLL.

Validating the ALLL Methodology

An institution's ALLL methodology is considered valid when it
accurately estimates the amount of loss contained in the portfolio.
Thus, the institution's methodology should include procedures that
adjust loss estimation methods to reduce differences between estimated
losses and actual subsequent charge-offs, as necessary.

To verify that the ALLL methodology is valid and conforms to GAAP
and supervisory guidance, an institution's directors should establish
internal control policies, appropriate for the size of the institution
and the type and complexity of its loan products. These policies should
include procedures for a review, by a party who is independent of the
ALLL estimation process, of the ALLL methodology and its application in
order to confirm its effectiveness.

In practice, financial institutions employ numerous procedures when
validating the reasonableness of their ALLL methodology and determining
whether there may be deficiencies in their overall methodology or loan
grading process. Examples are:

(1) A review of trends in loan volume, delinquencies,
restructurings, and concentrations.

(2) A review of previous charge-off and recovery history,
including an evaluation of the timeliness of the entries to record both
the charge-offs and the recoveries.

(3) A review by a party that is independent of the ALLL
estimation process. This often involves the independent party
reviewing, on a test basis, source documents and underlying assumptions
to determine that the established methodology develops reasonable loss
estimates.

(4) An evaluation of the appraisal process of the underlying
collateral. This may be accomplished by periodically comparing the
appraised value to the actual sales price on selected properties sold.

Supporting Documentation for the Validation Process

Management usually supports the validation process with the
workpapers from the ALLL review function. Additional documentation
often includes the summary findings of the independent reviewer. The
institution's board of directors, or its designee, reviews the
findings and acknowledges its review in its meeting minutes. If the
methodology is changed based upon the findings of the validation
process, documentation that describes and supports the changes should
be maintained.

Appendix A--ALLL Questions and Answers

Introduction

The Questions and Answers (Q&As) presented in this appendix serve
several purposes, including (1) To illustrate the banking agencies'
views, as set forth in this Policy Statement, about the types of
decisions, determinations, and processes an institution should document
with respect to its ALLL methodology and amounts; and (2) to illustrate
the types of ALLL documentation and processes an institution might
prepare, retain, or use in a particular set of circumstances. The level
and types of documentation described in the Q&As should be considered
neither the minimum acceptable level of documentation nor an
all-inclusive list. Institutions are expected to apply the guidance in
this Policy Statement to their individual facts, circumstances, and
situations. If an institution's fact pattern differs from the fact
patterns incorporated in the following Q&As, the institution may decide
to prepare and maintain different types of documentation than did the
institutions depicted in these Q&As.

Q&As #1ALLL Under FAS 114Measuring and Documenting Impairment

Facts: Approximately one-third of Institution A's
commercial loan portfolio consists of large balance, non-homogeneous
loans. Due to their large individual balances, these loans meet the
criteria under Institution A's policies and procedures for individual
review for impairment under FAS 114. Upon review of the large balance
loans, Institution A determines that certain of the loans are impaired
as defined by FAS 114.

Question: For the commercial loans reviewed under FAS 114
that are individually impaired, how should Institution A measure and
document the impairment on those loans? Can it use an impairment
measurement method other than the methods allowed by FAS 114?

Interpretive Response: For those loans that are reviewed
individually under FAS 114 and considered individually impaired,
Institution A must use one of the methods for measuring impairment that
is specified by FAS 114 (that is, the present value of expected future
cash flows, the loan's observable market price, or the fair value of
collateral). Accordingly, in the circumstances described above, for the
loans considered individually impaired under FAS 114, it would not be
appropriate for Institution A to choose a measurement method not
prescribed by FAS 114. For example, it would not be appropriate to
measure loan impairment by applying a loss rate to each loan based on
the average historical loss percentage for all of its commercial loans
for the past five years.

Institution A should maintain, as sufficient, objective evidence,
written documentation to support its measurement of loan impairment
under FAS 114. If Institution A uses the present value of expected
future cash flows to measure impairment of a loan, it
should
document the amount and timing of cash flows,
the effective interest rate used to discount the cash flows, and the
basis for the determination of cash flows, including consideration of
current environmental factor1
and other information reflecting past events and current conditions. If
Institution A uses the fair value of collateral to measure impairment,
it should document how it determined the fair value, including the use
of appraisals, valuation assumptions and calculations, the supporting
rationale for adjustments to appraised values, if any, and the
determination of costs to sell, if applicable, appraisal quality, and
the expertise and independence of the appraiser. Similarly, Institution
A should document the amount, source, and date of the observable market
price of a loan, if that method of measuring loan impairment is used.

Facts: Institution B has a $10 million loan outstanding
to Company X that is secured by real estate, which Institution B
individually evaluates under FAS 114 due to the loan's size. Company X
is delinquent in its loan payments under the terms of the loan
agreement. Accordingly, Institution B determines that its loan to
Company X is impaired, as defined by FAS 114. Because the loan is
collateral dependent, Institution B measures impairment of the loan
based on the fair value of the collateral. Institution B determines
that the most recent valuation of the collateral was performed by an
appraiser eighteen months ago and, at that time, the estimated value of
the collateral (fair value less costs to sell) was $12 million.

Institution B believes that certain of the assumptions that were
used to value the collateral eighteen months ago do not reflect current
market conditions and, therefore, the appraiser's valuation does not
approximate current fair value of the collateral. Several buildings,
which are comparable to the real estate collateral, were recently
completed in the area, increasing vacancy rates, decreasing lease
rates, and attracting several tenants away from the borrower.
Accordingly, credit review personnel at Institution B adjust certain of
the valuation assumptions to better reflect the current market
conditions as they relate to the loan's
collateral.2
After adjusting the collateral valuation assumptions, the credit review
department determines that the current estimated fair value of the
collateral, less costs to sell, is $8 million. Given that the recorded
investment in the loan is $10 million, Institution B concludes that the
loan is impaired by $2 million and records an allowance for loan losses
of $2 million.

Question: What type of documentation should Institution B
maintain to support its determination of the allowance for loan losses
of $2 million for the loan to Company X?

Interpretive Response: Institution B should document that
it measured impairment of the loan to Company X by using the fair value
of the loan's collateral less costs to sell, which it estimated to be
$8 million. This documentation should include the institution's
rationale and basis for the $8 million valuation, including the revised
valuation assumptions it used, the valuation calculation, and the
determination of costs to sell, if applicable. Because Institution B
arrived at the valuation of $8 million by modifying an earlier
appraisal, it should document its rational and basis for the changes it
made to the valuation assumptions that resulted in the collateral value
declining from $12 million eighteen months ago to $8 million in the
current period.3

Q&A #3ALLL Under FAS 114Fully Collateralized Loans

Facts: Institution C has $10 million in loans that are
fully collateralized by highly rated debt securities with readily
determinable market values. The loan agreement for each of these loans
requires the borrower to provide qualifying collateral sufficient to
maintain a loan-to-value ratio with sufficient margin to absorb
volatility in the securities' market prices. Institution C's
collateral department has physical control of the debt securities
through safekeeping arrangements. In addition, Institution C perfected
its security interest in the collateral when the funds were originally
distributed. On a quarterly basis, Institution C's credit
administration function determines the market value of the collateral
for each loan using two independent market quotes and compares the
collateral value to the loan carrying value. If there are any
collateral deficiencies, Institution C notifies the borrower and
requests that the borrower immediately remedy the deficiency. Due in
part to its efficient operation, Institution C has historically not
incurred any material losses on these loans. Institution C believes
these loans are fully-collateralized and therefore does not maintain
any ALLL balance for these loans.

Questions: What documentation does Institution C maintain
to adequately support its determination that no allowance is needed for
this group of loans?

Interpretive Response: Institution C's management
summary of the ALLL includes documentation indicating that, in
accordance with the institution's ALLL policy, the collateral
protection on these loans has been verified by the institution, no
probable loss has been incurred, and no ALLL is necessary.
Documentation in Institution C's loan files includes the two
independent market quotes obtained each quarter for each loan's
collateral amount, the documents evidencing the perfection of the
security interest in the collateral, and other relevant supporting
documents. Additionally, Institution C's ALLL policy includes a
discussion of how to determine when a loan is considered "fully
collateralized" and does not require an ALLL. Institution C's
policy requires the following factors to be considered and the
institution's findings concerning these factors to be fully
documented:

(1) Volatility of the market value of the collateral;

(2) Recency and reliability of the appraisal or other valuation

(3) Recency of the institution's or third party's inspection of
the collateral

(4) Historical losses on similar loans;

(5) Confidence in the institution's lien or security position
including appropriate:

(b) Filing of security perfection (i.e., correct documents and
with the appropriate officials); and

(c) Relationship to other liens; and

(6) Other factors as appropriate for the loan type.

Q&A #4ALLL Under FAS 5Adjusting Loss Rates

Facts: Institution D's lending area includes a
metropolitan area that is financially dependent upon the profitability
of a number of manufacturing businesses. These businesses use highly
specialized equipment and significant quantities of rare metals in the
manufacturing process. Due to increased low-cost foreign competition,
several of the parts suppliers servicing these manufacturing firms
declared bankruptcy. The foreign suppliers have subsequently increased
prices and the manufacturing firms have suffered from increased
equipment maintenance costs and smaller profit margins. Additionally,
the cost of the rare metals used in the manufacturing process increased
and has now stabilized at double last year's price. Due to these
events, the manufacturing businesses are experiencing financial
difficulties and have recently announced downsizing plans.

Although Institution D has yet to confirm an increase in its loss
experience as a result of these events, management knows that it lends
to a significant number of businesses and individuals whose repayment
ability depends upon the long-term viability of the manufacturing
businesses. Institution D's management has identified particular
segments of its commercial and consumer customer bases that include
borrowers highly dependent upon
sales or salary from the manufacturing
businesses. Institution D's management performs an analysis of the
affected portfolio segments to adjust its historical loss rates used to
determine the ALLL. In this particular case, Institution D has
experienced similar business and lending conditions in the past that it
can compare to current conditions.

Question: How should Institution D document its support
for the loss rate adjustments that result from considering these
manufacturing firms' financial downturns?

Interpretive Response: Institution D should document its
identification of the particular segments of its commercial and
consumer loan portfolio for which it is probable that the manufacturing
business' financial downturn has resulted in loan losses. In addition,
Institution D should document its analysis that resulted in the
adjustments to the loss rates for the affected portfolio segments. As
part of its documentation, Institution D maintains copies of the
documents supporting the analysis, including relevant newspaper
articles, economic reports, economic data, and notes from discussions
with individual borrowers.

Because in this case Institution D has had similar situations in the
past, its supporting documentation also includes an analysis of how the
current conditions compare to its previous loss experiences in similar
circumstances. As part of its effective ALLL methodology, Institution D
creates a summary of the amount and rationale for the adjustment
factor, which management presents to the audit committee and board for
their review and approval prior to the issuance of the financial
statements.

Q&A #5ALLL Under FAS 5Estimating Losses on Loans Individually
Reviewed for Impairment But Not Considered Individually Impaired.

Facts: Institution E has outstanding loans of $2 million
to Company Y and $1 million to Company Z, both of which are paying as
agreed upon in the loan documents. The institution's ALLL policy
specifies that all loans greater than $750,000 must be individually
reviewed for impairment under FAS 114. Company Y's financial
statements reflect a strong net worth, good profits, and ongoing
ability to meet debt service requirements. In contract, recent
information indicates Company Z's profitability is declining and its
cash flow is tight. Accordingly, this loan is rated substandard under
the institution's loan grading system. Despite its concern, management
believes Company Z will resolve its problems and determines that
neither loan is individually impaired as defined by FAS 114.

Institution E segments its loan portfolio to estimate loan losses
under FAS 5. Two of its loan portfolio segments are Segment 1 and
Segment 2. The loan to Company Y has risk characteristics similar to
the loans included in Segment 1 and the loan to Company Z has risk
characteristics similar to the loans included in Segment
2.4

In its determination of the ALLL under FAS 5, Institution E includes
its loans to Company Y and Company Z in the groups of loans with
similar characteristics (i.e., Segment 1 for Company Y's loan and
Segment 2 for Company Z's loan). Management's analyses of Segment 1
and Segment 2 indicate that it is probable that each segment includes
some losses, even though the losses cannot be identified to one or more
specific loans. Management estimates that the use of its historical
loss rates for these two segments, with adjustments for changes in
environmental factors provides a reasonable estimate of the
institution's probable loan losses in these segments.

Question: How does Institution E adequately document an
ALLL under FAS 5 for these loans that were individually reviewed for
impairment but are not considered individually impaired?

Interpretive Response: As part of Institution E's
effective ALLL methodology, it documents the decision to include its
loans to Company Y and Company Z in its determination of its ALLL under
FAS 5. It also documents the specific characteristics of the loans that
were the basis for grouping these loans with other loans in Segment 1
and Segment 2, respectively. Institution E maintains documentation to
support its method of estimating loan losses for Segment 1 and Segment
2, including the average loss rate used, the analysis of historical
losses by loan type and by internal risk rating, and support for
any
adjustments to its historical loss rates. The
institution also maintains copies of the economic and other reports
that provided source data.

Q&A #6Consolidating the Loss EstimatesDocumenting the Reported
ALLL

Facts: Institution F determines its ALLL using an
established systematic process. At the end of each period, the
accounting department prepares a summary schedule that includes the
amount of each of the components of the ALLL, as well as the total ALLL
amount, for review by senior management, the Credit Committee, and,
ultimately, the board of directors. Members of senior management and
the Credit Committee meet to discuss the ALLL. During these
discussions, they identify changes that are required by GAAP to be made
to certain of the ALLL estimates. As a result of the adjustments made
by senior management, the total amount of the ALLL changes. However,
senior management (or its designee) does not update the ALLL summary
schedule to reflect the adjustments or reasons for the adjustments.
When performing their audit of the financial statements, the
independent accountants are provided with the original ALLL summary
schedule that was reviewed by senior management and the Credit
Committee, as well as a verbal explanation of the changes made by
senior management and the Credit Committee when they met to discuss the
loan loss allowance.

Question: Are Institution F's documentation practices
related to the balance of its loan loss allowance in compliance with
existing documentation guidance in this area?

Interpretive Response: No. An institution must maintain
supporting documentation for the loan loss allowance amount reported in
its financial statements. As illustrated above, there may be instances
in which ALLL reviewers identify adjustments that need to be made to
the loan loss estimates. The nature of the adjustments, how they were
measured or determined, and the underlying rationale of making the
changes to the ALLL balance should be documented. Appropriate
documentation of the adjustments should be provided to the board of
directors (or its designee) for review of the final ALLL amount to be
reported in the financial statements. For institutions subject to
external audit, this documentation should also be made available to the
independent accountants. If changes frequently occur during management
or credit committee reviews of the ALLL, management may find it
appropriate to analyze the reasons for the frequent changes and to
reassess the methodology the institution uses.

Appendix BApplication of GAAP

An ALLL recorded pursuant to GAAP is an institution's best estimate
of the probable amount of loans and lease-financing receivables that it
will be unable to collect based on current information and
events.1
A creditor should record an ALLL when the criteria for accrual of a
loss contingency as set forth in GAAP have been met. Estimating the
amount of an ALLL involves a high degree of management judgment and is
inevitably imprecise. Accordingly, an institution may determine that
the amount of loss falls within a range. An institution should record
its best estimate within the range of loan
losses.2

Under GAAP, Statement of Financial Accounting Standards No. 5,
Accounting for Contingencies (FAS 5), provides the basic guidance for
recognition of a loss contingency, such as the collectibility of loans
(receivables), when it is probable that a loss has been
incurred and the amount can be reasonably
estimated. Statement of Financial Accounting Standards No. 114,
Accounting by Creditors for Impairment of a Loan (FAS 114) provides
more specific guidance about the measurement and disclosure of
impairment for certain types of
loans.3
Specifically, FAS 114 applies to loans that are identified for
evaluation on an individual basis. Loans are considered impaired when,
based on current information and events, it is probable that the
creditor will be unable to collect all interest and principal payments
due according to the contractual terms of the loan agreement.

For individually impaired loans, FAS 114 provides guidance on the
acceptable methods to measure impairment. Specifically, FAS 114 states
that when a loan is impaired, a creditor should measure impairment
based on the present value of expected future principal and interest
cash flows discounted at the loan's effective interest rate, except
that as a practical expedient, a creditor may measure impairment based
on a loan's observable market price or the fair value of collateral,
if the loan is collateral dependent. When developing the estimate of
expected future cash flows for a loan, an institution should consider
all available information reflecting past events and current
conditions, including the effect of existing environmental factors. The
following Illustration provides an example of an institution estimating
a loan's impairment when the loan has been partially charged-off.

Begin Text Box--Illustration (Interaction of FAS 114 With
an Adversely Classified Loan, Partial Charge-off, and the Overall
ALLL): An institution determined that a collateral dependent loan,
which it identified for evaluation, was impaired. In accordance with
FAS 114, the institution established an ALLL for the amount that the
recorded investment in the loan exceeded the fair value of the
underlying collateral, less costs to sell. Consistent with relevant
regulatory guidance, the institution classified as "Loss," the
portion of the recorded investment deemed to be the confirmed loss and
classified the remaining recorded investment as "Substandard."
For this loan, the amount classified "Loss" was less than the
impairment amount (as determined under FAS 114). The institution
charged off the "Loss" portion of the loan. After the charge-off,
the portion of the ALLL related to this "Substandard" loan (1)
reflects an appropriate measure of impairment under FAS 114, and (2) is
included in the aggregate FAS 114 ALLL for all loans that were
identified for evaluation and individually considered impaired. The
aggregate FAS 114 ALLL is included in the institution's overall ALLL.
End Text Box

Large groups of smaller-balance homogeneous loans that are
collectively evaluated for impairment are not included in the scope of
FAS 114.4
Such groups of loans may include, but are not limited to, credit card,
residential mortgage, and consumer installment loans. FAS 5 addresses
the accounting for impairment of these loans. Also, FAS 5 provides the
accounting guidance for impairment of loans that are not identified for
evaluation on an individual basis and loans that are individually
evaluated but are not individually considered impaired.

Institutions should ensure that they do not layer their loan loss
allowances. Layering is the inappropriate practice of recording in the
ALLL more than one amount for the same probable loan loss. Layering can
happen when an institution includes a loan in one segment, determines
its best estimate of loss for that loan either individually or on a
group basis (after taking into account all appropriate environmental
factors, conditions, and events), and then includes the loan in another
group, which receives an additional ALLL
amount.5

While different institutions may use different methods, there are
certain common elements that should be included in any loan loss
allowance methodology. Generally, an institution's methodology
should:6

(1) Include a detailed analysis of the loan portfolio, performed
on a regular basis;

(2) Consider all loans (whether on an individual or group basis);

(3) Identify loans to be evaluated for impairment on an
individual basis under FAS 114 and segment the remainder of the
portfolio into groups of loans with similar risk characteristics for
evaluation and analysis under FAS 5;

(4) Consider all known relevant internal and external factors
that may affect loan collectibility;

(5) Be applied consistently but, when appropriate, be modified
for new factors affecting collectibility;

(6) Consider the particular risks inherent in different kinds of
lending;

(8) Require that analyses, estimates, reviews and other ALLL
methodology functions be performed by competent and well-trained
personnel;

(9) Be based on current and reliable data;

(10) Be well documented, in writing, with clear explanations of
the supporting analyses and rationale; and

(11) Include a systematic and logical method to consolidate the
loss estimates and ensure the ALLL balance is recorded in accordance
with GAAP.

A systematic methodology that is properly designed and implemented
should result in an institution's best estimate of the ALLL.
Accordingly, institutions should adjust their ALLL balance, either
upward or downward, in each period for differences between the results
of the systematic determination process and the unadjusted ALLL balance
in the general ledger.7

Bibliography

American Institute of Certified Public
Accountants' Audit and Accounting Guide, Banks and Savings
Institutions, 2000 edition

1A bibliography is attached that lists applicable ALLL GAAP
guidance, interagency statements, and other reference materials that
may assist in understanding and implementing an ALLL in accordance with
GAAF. See Appendix B for additional information on applying GAAP to
determine the ALLL. Go back to Text

2All institutions are encouraged to establish audit committees;
however, at small institutions without audit committees, the board of
directors retains this responsibility. Go back to Text

3Institutions and their auditors should refer to Statement on
Auditing Standards No. 61, Communication With Audit Committees (as
amended by Statement on Auditing Standards No. 90, Audit Committee
Communications), which requires certain discussions between the auditor
and the audit committee. These discussions should include items, such
as accounting policies and estimates, judgments, and uncertainties that
have a significant impact on the accounting information included in the
financial statements. Go back to Text

4The banking agencies are the Federal Deposit Insurance
Corporation, the Federal Reserve Board, the Office of the Comptroller
of the Currency, and the Office of Thrift Supervision. Go back to Text

5Institutions should refer to the guidelines adopted by their
primary federal regulator as follows: For national banks, Appendix A to
Part 30; for state member banks, Appendix D to Part 208; for state
nonmember banks, Appendix
A to Part 364; for savings associations, Appendix A to Part
570. Go back to Text

7Failure to maintain adequate supporting documentation does not
relieve an institution of its obligation to record an appropriate
ALLL. Go back to Text

8This position is fully described in the SEC's FRR 28, in
which the SEC indicates that the books and records of public companies
engaged in lending activities should include documentation of the
rationale supporting each period's determination that the ALLL and
provision amounts reported were adequate. Go back to Text

9Further explanation is presented in the Methodology section
that appears below. Go back to Text

10In addition to the supporting documentation requirements for
financial institutions, as described in interagency asset quality
guidelines, public companies are required to comply with the books and
records provisions of the Securities Exchange Act of 1934 (Exchange
Act). Under Sections
13(b)(2)--(7) of the Exchange Act, registrants must make and
keep books, records, and accounts, which, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of
assets of the registrant. Registrants also must maintain internal
accounting controls that are sufficient to provide reasonable
assurances that, among other things, transactions are recorded as
necessary to permit the preparation of financial statements in
conformity with GAAP. See also SEC Staff Accounting Bulletin No. 99,
Materiality. Go back to Text

12The referenced "gray box" illustrations are presented
to assist institutions in evaluating how to implement the guidance
provided in this document. The methods described in the illustrations
may not be suitable for all institutions and are not considered
required processes or actions. For additional descriptions of key
aspects of ALLL guidance, a series of ALLL Questions and Answers (Q&As)
are included in Appendix A of this paper. Go back to Text

13An example of a loan segment that does not generally require
an ALLL is loans that are fully secured by deposits maintained at the
lending institution. Go back to Text

14Refer to paragraph 8(b) of FAS 5. Also, the AICPA is
currently developing a Statement of Position that will provide more
specific guidance on accounting for loan losses. Go back to Text

17Subsequent to adjustments, there should be no material
differences between the consolidated loss estimate, as determined by
the methodology, and the final ALLL balance reported in the financial
statements. Go back to Text

1Question #16 in Exhibit D--80A of EITF Topic D--80 and
attachments indicates that environmental factors include existing
industry, geographical, economic, and political factors. Go back to Text

2When reviewing collateral dependent loans, Institution B may
often find it more appropriate to obtain an updated appraisal to
estimate the effect of current market conditions on the appraised value
instead of internally estimating an adjustment. Go back to Text

3In accordance with the FFIEC's Federal Register Notice,
Implementation Issues Arising from FASB No. 114, "Accounting by
Creditors for Impairment of a Loan," published February 10, 1995 (60
FR 7966, February 10, 1995), impaired, collateral-dependent loans must
be reported at the fair value of collateral, less costs to sell, in
regulatory reports. This treatment is to be applied to all
collateral-dependent loans, regardless of type of collateral. Go back to Text

4These groups of loans do not include any loans that have been
individually reviewed for impairment under FAS 114 and determined to be
impaired as defined by FAS 114. Go back to Text

1This Appendix provides guidance on the ALLL and does not
address allowances for credit losses for off-balance sheet instruments
(e.g., loan commitments, guarantees, and standby letters of credit).
Institutions should record liabilities for these exposures in
accordance with GAAP. Further guidance on this topic is presented in
the American Institute of Certified Public Accountants' Audit and
Accounting Guide, Banks and Savings Institutions, 2000 edition (AICPA
Audit Guide). Additionally, this Appendix does not address allowances
or accounting for assets or portions of assets sold with recourse,
which is described in Statement of Financial Accounting Standards No.
140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities--a Replacement of FASB Statement No. 125
(FAS 140). Go back to Text

3EITF Topic D--80 includes additional guidance on the
requirements of FAS 5 and FAS 114 and how they relate to each other.
The AICPA is currently developing a Statement of Position (SOP) that
will provide more specific guidance on accounting for loan losses. Go back to Text

4In addition, FAS 114 does not apply to loans measured at fair
value or at the lower of cost or fair value, leases, or debt
securities. Go back to Text

5According to the Federal Financial Institutions Examination
Council's Federal Register Notice, Implementation Issues Arising from
FASB Statement No. 114, Accounting by Creditors for Impairment of a
Loan, published February 10, 1995, institution-specific issues should
be reviewed when estimating loan losses under FAS 114. This analysis
should be conducted as part of the evaluation of each individual loan
reviewed under FAS 114 to avoid potential ALLL layering. Go back to Text